One of the most critical and least known questions facing sellers, agents and lenders is whether the lender can really come after a borrower for a deficiency after a Short Sale. While the answers may vary according to the laws of your State, here in California the answer is a solid “maybe”.  Meanwhile, lenders will continue to seek to put deficiency recourse language in their Short Sale Consent Agreements and the borrowers and their agents will continue to seek the removal of that language.  While the presence or absence of recourse language may be enough for the Courts, that remains unclear for the reasons set forth below. This lack of certainty causes many short sales to fail and, until this issue winds its way through the legal system, no-one can know for sure whether a lender has any rights to collect a deficiency . But there are good arguments for both sides. 

A.  LENDER ARGUMENTS IN FAVOR OF RECOURSE:

1)   It is a Modification not a Release - A short sale is in effect a modification of the terms of the loan.  The lender has agreed to release their lien on the borrowers property so the property can be sold.  The lender agrees to do this without getting paid in full.  Arguably, the Short Sale agreement only modifies the terms referenced in the agreement. Unless the short sale agreement expressly waives recourse against the borrower for the unpaid balance, the lender may argue that they still possess the right to collect on the deficiency after the short sale is completed. 

2.  Unfair to penalize lender if Borrower is otherwise liable - In California, some loans are non-recourse such as a loan obtained to buy the home you live in. However, these “anti-deficiency” protections kick in when there is a foreclosure. These rules might not apply in a voluntary transfer such as a short sale. When there are no such protections, ie: non-purchase money or refinance or investor loan, the lender could have recourse against the borrower through the foreclosure method used. So, lenders would argue it is not fair to deny them the recourse that the borrower already agreed to in the loan.

B.    BORROWER ARGUMENTS AGAINST RECOURSE

1.   Short Sale is an “Accord and Satisfaction” - The short sale is inherently an agreement for resolution of a dispute between the borrower and the lender as to how much must the borrower pay.  In completing the short sale and receiving money they otherwise would not have received, they have arguable settled all claims. The “Accord” is the agreement; the “Satisfaction” is the money the lender received.

2.  Seeking Deficiency Violates the “Single Action Rule” - California only allows a lender one shot at collecting a debt. Arguably, the negotiation of the short sale and the lender’s acceptance of money from the Buyer is a collection action. If so, then the lender would be legally barred from filing a lawsuit against the borrower to collect anything else.

3.  Seeking Deficiency Violates the “Anti-Waiver Rule” - California real estate law provides that, if there is a default, the lender must take the security first (foreclose on the property) before going after the borrower for anything else.  There are only a few exceptions to this Rule which could allow a lender to “waive” the security and sue the buyer, ie: such as bringing hazardous waste onto the property; or destroying the property’s value by stripping out the plumbing or electrical systems.  These conditions do not exist in a short sale. Yet arguably what the lenders are doing is waiving the security to allow the short sale to be completed. If that is in fact a legal “waiver”, then the lender may be legally barred from coming after the borrower for a deficiency.

4.  No “Consideration” for waiving or modifying - Any contract or any modification requires that there be an equal trade of benefits and burdens. The borrower gets the benefit of the loans to buy the property but also gets the burden of having to repay what they received.  The value of what is exchanged by each of the parties is called the “legal consideration”. When only one side gets a benefit, there is what is called a “failure of consideration” and the contract may not be enforceable.  Arguably, this same requirement exists in a short sale:  the lender is getting money now and that’s a benefit but what is the benefit to the borrower?  They’re losing their property: that’s not a benefit;  they’re getting no money out of the deal: that’s not a benefit; they’re going to get taxed on any debt forgiveness: that’s not a benefit;  If the lender does have a right to pursue deficiency recourse against them, that’s definately not a benefit.  So, what benefit does the borrower get out of a short sale that would be sufficient consideration fore remaining liable for a deficiency?  Not much, if anything at all.  Arguably then, if the consideration is insufficient, then the lender’s right to waive the security and pursue a deficiency should fail for lack of consideration.

5.  Additional Arguments - Creative attorneys will find a fertile field of additional legal arguments to be raised in defending borrowers against lender deficiency claims. These can include a) the loan should never have been made; and b) the lenders caused the crash, why should they profit from it.

Who’s arguments prevail will be determined in the Courtrooms across our Country in the next few years to come. Initially rulings will be made by Judges in the local courts and they could vary greatly. In time, these inconsistent rulings will be challenged in the Courts of Appeal until a clear legal answer becomes apparent. Of course, Congress could pass a law and give us an answer now but I wouldn’t hold my breath waiting for that to happen.  Meanwhile Lenders will seek to put language in their Short Sale Consent Agreements requiring the borrower to agree to deficiency liability

If you have specific questions about your liability, short sales, foreclosure, or any legal issues, feel free to contact me at sjbeede@bpelaw.com.  We offer a $200 flat fee consultation to evaluate your liabilities and strategize a resolution. This can be done in person or by phone. If interested, please call us at 916-966-2260. Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/

The wave of possible lender lawsuits against borrowers has started, primarily by junior lenders whose seconds (often HELOCS) were wiped out when a senior lender foreclosed.  We presently are representing borrowers in a number of these lawsuits and have already settled several. The most important points to remember if you are served with a lawsuit are: 1) don’t panic and ignore it. Get competent legal counsel in your State to advise you how and when to respond; and 2) almost all such lawsuits will resolve without going to trial.

There are several defenses that can be raised in defense to any lender lawsuit that may reduce or even eliminate their claim. These include:

1. Lender does not own the loan - In order to file a lawsuit against you, the lender must actually “own” the loan, that is they own and have possession of the Promissory Note.  Loans change ownership all the time and it is possible that the lawsuit has been brought by a loan “servicer” or collection company, not the actual owner. If they cannot prove ownership, they do not have “legal standing” to file the lawsuit and they should lose.

2. Loan was predatory - One of the key reasons why we had this market collapse was that from 2000 through 2006, lenders made loans to borrowers who in reality could not afford the loan.  Sometime this was done by misstating income on “stated income” or “no document” loans and often this misstatement was done by the lender, not the borrower. Other times the loan was unrealistic, such as a 1% interest rate on which the borrower qualified for the loan but which jumped up much higher after the first month.  So the buyer only qualified on month one but would never qualify on month two.  Failure was inevitable unless the buyer could quickly flip the property.  If the lender should never have made the loan, they likely will not recover against the borrower in court.

3. Loan was result of fraud - Similar to predatory loans, many borrowers obtained loans through actual fraud where the loan agent altered information supplied by the borrower or made false representations to the borrower such as:  “take this adjustable rate now and we’ll convert it to a fixed rate within a year”. For most borrowers, that loan agent was never to be found within the year, the fixed rate was not obtainable, and the increasing adjustable rate forced the borrower into default.   If the lender’s loan agent defrauded the borrower into getting the loan, they likely will not recover against the borrower in court.

4. Lender failed to do diligence - One of the biggest causes of the market collapse was that the lenders failed to exercise any diligence in checking to make sure the information on the loan application was true, such as checking tax returns and confirming the borrowers employment and income.  The banking deregulation in the late 1990’s created a flood of money in the market for new loans to be made and lenders accepted virtually any application without checking whether the loan was good. The result was billions of dollars of bad loans secured with property that was not worth the debt.   If the lender should never have made the loan, they likely will not recover against the borrower in court.

5. Lender knew the market was inflated in a bubble - The combination of banking deregulation and easy money created a huge increase in demand by possible homeowners and investors which drove up the prices on available properties, often increasing by $10,000 or more in a single month.  Developers rushed in with new subdivisions everywhere trying to fill the demand as competition for homes kept driving prices upwards.  This inflationary bubble was almost entirely fueled by high-risk loans, speculative appraisals, and the lack of real underwriting and diligence by the lenders. It was completely foreseeable to lenders that this bubble would burst but they made the loans anyway because they earned commissions and could sell the loans in the secondary mortgage market.  It was no real surprise to lenders when the borrowers started defaulting in 2005 on the increasingly expensive loans which led to the collapse starting in 2006.  If the lender should never have made the loan, they likely will not recover against the borrower in court.

6. Lender has insurance for the loss - Many of the loans made were 100% of purchase price and even more. Generally, if the loan was for more than 80% of the property value, mortgage insurance (PMI) was required. Although paid for by the borrower, this insurance paid the lender for any loss on a default. The lawsuit may be an attempt by the lender to collect on a loss that they have already recovered on through the insurance. If the lender has already been compensated for any loss, they likely will not recover against the borrower in court.

7.  Lender has been bailed out by the taxpayers - Between 2008 and 2009, Federal bailout monies paid by taxpayers (including the borrower) provided protection for lenders damaged because of loan losses.  Our government guaranteed billions of dollars in lender bad debt, guarantees that we and our children will be paying for years to come. Many consider these bailouts to be a reward for bad business practices instead of the punishment that might be deserved. If the lender has already been compensated for any loss, they likely will not recover against the borrower in court.

How Should You Prepare? - In California, the deadline for a lender to bring a claim against a borrower is four years from the date the borrower defaulted. With hundreds of thousands of borrowers just now in default, these lawsuits will be a constant threat for many years to come.  These may be joined by deficiency lawsuits following short sales to which the same defenses can be raised in addition to several other defenses unique to short sales which I’ll cover in subsequent Blogs.

Before you make any decision concerning your upside-down home or investment property, be certain to get tax and legal advice from qualified professionals in your State who can look at your specific situation and advise you on how these rules apply to you, particularly on how to identify and minimize the risks of a lender lawsuit.  This Article is solely intended to give you an introduction to key legal concerns affecting borrowers today but you should not rely on it to apply to your financial circumstances.

If you have specific questions about your liability, short sales, foreclosure, or any legal issues, feel free to contact me at sjbeede@bpelaw.com.  We offer a $200 flat fee consultation to evaluate your liabilities and strategize a resolution. This can be done in person or by phone. If interested, please call us at 916-966-2260. Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/.